Tag: Financial Instruments

A third and an area of particular relevance to the Reserve Bank of India (RBI) relates to corporate governance in the financial sector. Today, therefore, the major focus of this presentation would relate to corporate governance in the financial sector itself.

It is possible to broadly identify different sets of players in the corporate governance system. For convenience they can be identified as law which is the legal system; regulators; the Board of Directors and Executive Directors on the Board; financial intermediaries; markets; and self regulatory organisations. There is a dynamic balance among them that determines the prevailing corporate governance system, and the balance varies from country to country. In some countries, self-regulatory organisations are well established and in others, as you are aware, the financial intermediaries play a greater part. These balances vary from country to country and, vary depending upon the stage of institutional development and the historical context. Since financial intermediaries are important players in corporate governance in India, special focus on the corporate governance in the financial sector itself becomes critical.

Secondly, the RBI, as regulator relevant to financial sector, has responsibility on the nature of corporate governance in the financial sector. Therefore, we, in the RBI, have to see how corporate governance is evolving, particularly in the context of the financial sector reforms that are being undertaken.

Third, banks are special and to the extent banks have systemic implications, corporate governance in the banks is of critical importance to the RBI.

Fourth, which is not peculiar, but certainly one of the important features of the Indian system, is the dominance of the Government or the public sector ownership in financial sector, whether it is the banking system or development financial institutions. In a way, Government, as a sole or significant owner of commercial, competitive, corporate entities in the financial sector would also set the standards for corporate governance in private sector.

Fifth, relates to the reform process initiated since 1991-92. In the pre-reform period, most decisions were externally, i.e., external to the financial intermediary determined including interest rates to be paid or charged and whom to lend. But recently, there has been a movement away from micro regulation by the RBI. There is thus, a shift from external regulation to the internal systems and therefore, the quality of the corporate governance within the bank or financial institution becomes critical in the performance of the financial sector and indeed the growth of financial sector.

In this perspective of the significance of corporate governance in the financial sector in India, the rest of the presentation is divided into three parts.

The first relates to corporate governance in Government owned financial intermediaries, i.e., the nature of the corporate governance in the context of the Government ownership.

The second set relates to corporate governance and regulatory issues in financial sector, especially relevant to the Reserve Bank of India.

The third part identifies the areas that require attention, taking into account not only the ownership and regulatory aspects but also the total systemic requirements. The areas requiring attention are simply listed for further attention.

Importance of Corporate Governance Under Government Ownership

The evolving corporate governance system in Government owned banks and financial institutions is very critical in India for a number of reasons.

First, public ownership is dominant in our financial sector and it is likely to be dominant for quite sometime in future in India. So, it sets a benchmark for the practices of corporate governance.

Second, the whole concept of competition in banking will have to be viewed in the light of the government ownership. If the regulator is trying to encourage competition, such encouragement of competition is possible if the market players i.e., banks concerned, are willing to respond to the competitive impulses that the regulator is trying to induce. It is possible that the nature of corporate arrangements and nature of incentive framework in the public sector banks are such the regulatory initiatives will not get the desired response or results. Consequently, the regulator’s inclination or pressure to create an incentive framework for introducing competition would also be determined by the extent to which the corporate governance in public sector financial intermediaries is conducive and responsive.

A third factor is diversified ownership in many public sector financial intermediaries, both the banks and financial institutions. The government is no longer 100 per cent owner in all public sector organisations. In organisations where there has been some divestment, it owns directly or indirectly about 55 to 70 per cent. The existence of private shareholders implies that issues like enhancing shareholders value, protecting shareholders value and protecting shareholders rights become extremely important. Such a situation did not exist in most of the public sector and financial sector until a few years back. The issue is whether this transformation in ownership pattern of the financial system has been captured in changing the framework of corporate governance.

A fourth factor is that if the financial sector, in particular banking system, has to develop in a healthy manner there is need for additional funding of these institutions. More so, when the central bank is justifiably prescribing better prudential requirements and capital adequacy norms. If some additional capital has to be raised by these institutions, they should be able to convince the capital market and shareholders that it is worth investing their money in. In the interest of ensuring that the institutions have adequate capital and that they continue to grow, they should be in a position to put in place and assure the market that their system of corporate governance is such that they can be trusted with shareholders money. The issue, therefore, is how our public sector financial institutions have been performing in terms of enhancing shareholder values. This is extremely important from system point of view because, additional funding has to be provided either by the Government or by the private shareholder. Given the fiscal position, the Government cannot be expected to invest significant funds in recapitalising public sector financial organisations. In brief, Government as an owner has to appreciate the importance of enhancing shareholder value, to reduce the possible fiscal burden of funding of banking or financial institutions in future and so attention to corporate governance in public sector is relevant from overall fiscal point of view also – whether for additional investment by Government or for successful divestment of its holdings.

Fifth, there is the issue of mixing up of regulatory, sovereign and, ownership functions and at the same time ensuring a viable system of corporate governance. A reference has been made to this in the Narasimham Committee Report on Banking Sector Reforms (Narasimham Committee II) Banking Sector Reforms and more recently in the Discussion Paper on Harmonising the Role and Operations of Development Financial Institutions and Banks (Discussion Paper on Universal Banking), circulated by the Reserve Bank of India. For instance, as the Narasimham Committee (II) has highlighted, in the case of the State Bank of India, the RBI is both regulator and owner. Also, ownership and regulatory functions are mixed up in the case of the Industrial Development Bank of India.

The Reserve Bank of India (RBI) is the central bank for India. The RBI handles many functions, from handling monetary policy to issuing currency. India has reported some of the best gross domestic product (GDP) growth rates in the world. It is also known as one of the four most powerful emerging market countries, collectively part of BRIC nations, which include Brazil, Russia, India, and China.

Prior to liberalization RBI used to regulate and control the financial sector that includes financial institutions like commercial banks investment banks stock exchange operations and foreign exchange market. With the economic liberalization and financial sector reforms RBI needed to shift its role from a controller to facilitator of the financial sector. This implies that the financial organisations were free to make their own decisions on many matters without consulting the RBI. This opened up the gates of financial sectors for the private players. The main objective behind the financial reforms was to encourage private sector participation increase competition and allowing market forces to operate in the financial sector. Thus it can be said that before liberalization RBI was controlling the financial sector operations whereas in the post-liberalization period the financial sector operations were mostly based on the market forces.

The International Monetary Fund (IMF) and World Bank have highlighted India in several reports showing its high rate of growth. In April 2019, the World Bank projected India’s GDP growth would expand by 7.5% in 2020.1 Also in April 2019, the IMF showed an expected GDP growth rate of 7.3% for 2019 and 7.5% for 2020.2 Both projections have India with the highest expected GDP growth in the world over the next two years.

As with all economies, the central bank plays a key role in managing and monitoring the monetary policies affecting both commercial and personal finance as well as the banking system. As GDP moves higher in the world rankings the RBI’s actions will become increasingly important.

In April 2019, the RBI made the monetary policy decision to lower its borrowing rate to 6%.3 The rate cut was the second for 2019 and is expected to help impact the borrowing rate across the credit market more substantially.4 Prior to April, credit rates in the country had remained relatively high, despite the central bank’s positioning, which has been limiting borrowing across the economy.

The central bank must also grapple with a slightly volatile inflation rate that is projected at 2.4% in 2019, 2.9% to 3% in the first half of 2020, and 3.5% to 3.8% in the second half of 2020.

The RBI also has control over certain decisions regarding the country’s currency. In 2016, it affected a demonetization of the currency, which removed Rs. 500 and Rs. 1000 notes from circulation, mainly in an effort to stop illegal activities. Post analysis of this decision shows some wins and losses. The demonetization of the specified currencies caused cash shortages and chaos while also requiring extra spending from the RBI for printing more money.

Quantitative measures:

It refers to those measures of RBI in which affects the overall money supply in the economy. Various instruments of quantitative measures are:

• Bank rate: it is the interest rate at which RBI provides long term loan to commercial banks. The present bank rate is 6.5%. It controls the money supply in long term lending through this instrument. When RBI increases bank rate the interest rate charged by commercial banks also increases. This, in turn, reduces demand for credit in the economy. The reverse happens when RBI reduces the bank rate.
• Liquidity adjustment facility: it allows banks to adjust their daily liquidity mismatches. It includes a Repo and reverse repo operations.
• Repo rate: Repo repurchase agreement rate is the interest rate at which the Reserve Bank provides short term loans to commercial banks against securities. At present, the repo rate is 6.25%.
• Reverse repo rate: It is the opposite of Repo, in which banks lend money to RBI by purchasing government securities and earn interest on that amount. Presently the reverse repo rate is 6%.
• Marginal Standing Facility (MSF): It was introduced in 2011-12 through which the commercial banks can borrow money from RBI by pledging government securities which are within the limits of the statutory liquidity ratio (SLR). Presently the Marginal Standing Facility rate is 6.5%.

Market stabilisation scheme (MSS): this instrument is used to absorb the surplus liquidity from the economy through the sale of short-dated government securities. The cash collected through this instrument is held in a separate account with the Reserve Bank. It was introduced in 2004. RBI had raised the ceiling of the market stabilisation scheme after demonetization in 2016.

Every Central Bank has to perform numerous promotional and development functions which vary from country to country. This is truer in a developing country like India where RBI has been performing the functions of the promoter of financial system along with several special functions and non-monetary functions.

• Promotion of Banking habits and expansion of banking system: It performs several functions to promote banking habits among different sections of the society and promotes the territorial and functional expansion of banking system. For this purpose, RBI has set several Institutions such as Deposit and Insurance Corporation 1962, the agricultural refinance Corporation in 1963, the IDBI in 1964, the UTI in 1964, the Investment Corporation of India in 1972, the NABARD in 1982, and national housing Bank in 1988 etc.
• Export promotion through refinance facility: RBI promotes export through the Export Credit and Guarantee Corporation (ECGC) and EXIM Bank. It provides refinance facility for export credit given by the scheduled commercial banks. The interest rate charged for this purpose is comparatively lower. ECGC provides insurance on export receivables whereas EXIM banks provide long-term finance to project exporters etc.
• Development of financial system: RBI promotes and encourages the development of Financial Institutions, financial markets and the financial instruments which is necessary for the faster economic development of the country. It encourages all the banking and non-banking financial institutions to maintain a sound and healthy financial system.
• Support for Industrial finance: RBI supports industrial development and has taken several initiatives for its promotion. It has played an important role in the establishment of industrial finance institutions such as ICICI Limited, IDBI, SIDBI etc. It supports small scale industries by ensuring increased credit supply. Reserve Bank of India directed the commercial banks to provide adequate financial and technical assistance through specialised Small-Scale Industries (SSI) branches.
• Support to the Cooperative sector: RBI supports the Cooperative sector by extending indirect finance to the state cooperative banks. It routes this finance mostly via the NABARD.
• Support for the agricultural sector: RBI provides financial facilities to the agricultural sector through NABARD and regional rural banks. NABARD provides short term and long-term credit facilities to the agricultural sector. RBI provides indirect financial assistance to NABARD by providing large amount of money through General Line of Credit at lower rates.
• Training provision to banking staff: RBI provides training to the staff of banking industry by setting up banker s training college at many places. Institutes like National Institute of Bank management (NIBM), Bank Staff College (BSC) etc. provide training to the Banking staff.
• Data collection and publication of reports: RBI collects data about interest rates, inflation, deflation, savings, investment etc. which is very helpful for researchers and policymakers. It publishes data on different sectors of the economy through its Publication division. It publishes weekly reports, annual reports, reports on trend and progress of commercial bank etc.

Before 1991, India’s financial sector was highly regulated, with the government maintaining tight control over interest rates, credit allocation, and foreign exchange transactions. However, the economic crisis of 1991, marked by a balance of payments problem and dwindling foreign exchange reserves, necessitated structural adjustments and economic reforms. To tackle these issues, the Indian government, under the guidance of then Finance Minister Dr. Manmohan Singh, initiated a series of liberalization measures that also extended to the financial sector.

Liberalization of the Financial Sector (1991-1997)

The initial phase of reforms focused on liberalizing the banking and financial markets, improving operational efficiency, and increasing competition in the sector. Some of the major reforms during this period:

• Introduction of the Narasimham Committee Report (1991):

The committee, chaired by M. Narasimham, was set up to recommend measures to reform the financial system. Its report laid the groundwork for liberalizing the banking sector, reducing government control, and increasing the role of market forces.

• Entry of Private Banks:

Reserve Bank of India (RBI) allowed the entry of private sector banks in 1993. This led to the establishment of institutions like HDFC Bank, ICICI Bank, and others, which enhanced competition and led to improved banking services.

• Capital Market Reforms:

The government introduced several reforms in the capital market to make it more transparent and efficient. The Securities and Exchange Board of India (SEBI) was empowered to regulate and supervise the securities market, bringing in measures like dematerialization of shares, electronic trading, and stricter disclosure norms.

• Privatization of Banks:

The government began reducing its stake in public sector banks, aiming for greater autonomy and improved performance. This was a move towards making public banks more competitive in the market.

• Interest Rate Deregulation:

RBI allowed market forces to determine interest rates on loans and deposits, which was a significant departure from the previous regime of administered interest rates.

Institutional Reforms (1997-2004)

During the late 1990s and early 2000s, the focus of financial sector reforms shifted to strengthening financial institutions and improving regulatory mechanisms. Key reforms in this period:

• Formation of the Financial Sector Legislative Reforms Commission (FSLRC) in 2009:

To address the growing need for a comprehensive legal and regulatory framework, the FSLRC was formed to recommend measures to modernize India’s financial sector laws and provide a cohesive regulatory framework for banks, securities markets, insurance, and pensions.

• Non-Banking Financial Companies (NBFCs):

RBI and the government began focusing on improving the regulation of NBFCs to bring them in line with the banking sector and prevent any systemic risks associated with their operation.

• Risk-based Supervision:

RBI shifted to a risk-based approach for supervising commercial banks, ensuring that they had sufficient capital buffers to absorb shocks and could weather financial instability. This approach was aimed at ensuring the health of the banking sector.

• Public Sector Bank Reforms:

The government continued to reduce its stake in public sector banks. The emphasis was on improving governance, transparency, and accountability within these banks. A series of reforms were introduced to modernize operations, improve customer service, and introduce new banking technologies.

Modernization and Technology Adoption (2004-2014):

In the period following 2004, India’s financial sector reforms focused heavily on technology adoption, financial inclusion, and strengthening the regulatory framework. Key reforms are:

• Introduction of the Goods and Services Tax (GST) in 2017:

Though the GST was not a part of the financial sector per se, it had a significant impact on the financial sector. The GST provided a single, unified tax regime, making the process of tax compliance more efficient and promoting a formal economy.

• Financial Inclusion:

Efforts to bring the unbanked population into the formal financial system were accelerated. The government launched several financial inclusion schemes like Pradhan Mantri Jan Dhan Yojana (PMJDY), which aimed to provide banking facilities to rural and remote areas.

• Insurance Reforms:

The Insurance Regulatory and Development Authority (IRDA) increased the foreign direct investment (FDI) cap in the insurance sector from 26% to 49%, allowing greater private and foreign sector participation. This helped in improving the insurance penetration and services in India.

• Capital Market Reforms:

SEBI continued its efforts to streamline capital market operations, improve transparency, and protect investor interests. The introduction of new regulations for mutual funds, equity derivatives, and greater focus on corporate governance helped improve investor confidence.

• Digital Banking and Payments:

The rise of mobile banking, UPI (Unified Payments Interface), and other fintech solutions revolutionized the Indian banking sector. This not only improved access to financial services but also helped streamline transactions, making them faster, cheaper, and more secure.

Recent Reforms and Current Developments (2014-Present)

In recent years, the Indian financial sector has seen several developments aimed at strengthening its resilience and making it more inclusive:

• Insolvency and Bankruptcy Code (IBC):

Enacted in 2016, the IBC aims to provide a time-bound process for the resolution of corporate insolvencies, enabling efficient recovery of defaulted loans and improving the health of the banking sector.

• Financial Technology (FinTech) Revolution:

The integration of artificial intelligence, machine learning, and blockchain into the financial services sector has led to rapid innovation, particularly in areas like digital payments, lending, and investment management.

• Banking Consolidation:

In 2019, the Indian government announced the merger of several public sector banks to create fewer but stronger and more competitive entities, aimed at improving efficiency and reducing operational costs.

• Implementation of the GST and Demonetization:

While GST helped streamline taxation in the economy, demonetization (2016) sought to reduce the informal economy and increase digital transactions, driving financial sector growth.

Money market is a financial market that facilitates the trading of short-term financial instruments with high liquidity and maturities of one year or less. It serves as a platform for borrowers to meet short-term funding needs and for lenders to invest excess funds securely. Key participants include central banks, commercial banks, non-banking financial institutions, and primary dealers. Common instruments traded in the money market include treasury bills, commercial papers, certificates of deposit, and repurchase agreements. The money market plays a crucial role in ensuring liquidity and stability in the financial system.

Organization of Money Market:

Money market is a component of the financial system where short-term borrowing, lending, buying, and selling of financial instruments with maturities of one year or less take place. It plays a crucial role in ensuring liquidity in the economy by facilitating the transfer of short-term funds among financial institutions, businesses, and governments. The organization of the money market includes various institutions, instruments, and participants that interact to fulfill short-term funding needs.

1. Structure of the Money Market

The money market in India is well-organized and comprises two broad segments:

(a) Organized Sector

The organized sector is regulated by the Reserve Bank of India (RBI) and includes formal institutions and instruments:

• Reserve Bank of India (RBI):

The RBI is the central authority that regulates and monitors the money market, ensuring liquidity and stability. It conducts monetary policy operations, such as open market operations (OMO) and repo rate adjustments, to control the money supply.

• Commercial Banks:

Commercial banks play a key role by lending and borrowing short-term funds. They participate actively in call money markets and interbank lending.

• Development and Cooperative Banks:

These banks cater to specific sectors and also participate in the money market to manage their liquidity requirements.

• Non-Banking Financial Companies (NBFCs):

NBFCs participate in money market transactions to meet short-term financing needs.

• Primary Dealers:

Authorized primary dealers help in the development of government securities and participate in short-term borrowing through treasury bills.

(b) Unorganized Sector

The unorganized sector includes informal financial entities such as moneylenders, indigenous bankers, and traders. Though this sector is not regulated by the RBI, it plays a significant role in providing short-term funds, especially in rural areas.

2. Instruments of the Money Market

Several financial instruments are used in the money market, including:

• Treasury Bills (T-Bills):

Short-term government securities issued by the RBI on behalf of the government, typically with maturities of 91, 182, and 364 days.

• Commercial Paper (CP):

Unsecured promissory notes issued by corporations to raise short-term funds.

• Certificates of Deposit (CD):

Negotiable instruments issued by banks to raise short-term deposits from investors.

• Call Money and Notice Money:

Call money refers to funds borrowed or lent for a very short period, usually one day. Notice money involves borrowing for 2 to 14 days.

• Repo and Reverse Repo Agreements:

These are short-term borrowing agreements in which securities are sold and repurchased at a future date.

3. Participants in the Money Market

• Commercial banks
• Non-banking financial institutions
• Primary dealers
• Mutual funds
• Insurance companies
• Corporations

Defects of Money Market:

• Lack of Integration

The money market in many developing countries lacks proper integration between its various components, such as the central bank, commercial banks, and non-banking financial institutions. This fragmentation reduces the market’s overall efficiency in meeting liquidity demands uniformly.

• Limited Instruments

In well-developed money markets, a variety of financial instruments, such as treasury bills, commercial papers, and certificates of deposit, are actively traded. However, in underdeveloped markets, there is often a limited range of instruments, leading to reduced options for investors and borrowers.

• Seasonal Fluctuations

A major defect in certain money markets is the occurrence of seasonal fluctuations in demand for funds. For instance, in agriculture-driven economies, the demand for short-term funds increases sharply during sowing and harvesting seasons, leading to interest rate volatility.

• Ineffective Central Bank Control

The central bank is responsible for regulating and stabilizing the money market. In some economies, the central bank’s control mechanisms may not be well-developed or effectively enforced, resulting in unstable interest rates and liquidity imbalances.

• Limited Participation by Institutions

A healthy money market requires active participation from a wide range of financial institutions, including commercial banks, non-banking financial companies (NBFCs), and mutual funds. In certain markets, institutional participation is low, which limits the depth and breadth of the market.

• Underdeveloped Banking System

A weak or underdeveloped banking system can significantly hamper the functioning of the money market. In many countries, commercial banks may lack sufficient resources or the necessary infrastructure to actively participate in money market operations, leading to reduced liquidity.

• High Transaction Costs

In some money markets, high transaction costs can deter participation by smaller institutions and investors. These costs can include regulatory fees, brokerage charges, and administrative expenses, making short-term borrowing and lending less attractive.

• Lack of Transparency

Transparency is essential for the efficient functioning of the money market. In some economies, a lack of clear information about interest rates, market demand, and supply of funds can result in inefficient allocation of resources and increased risks for participants.

Dealers of Money Market:

• Central Bank

The central bank, such as the Reserve Bank of India (RBI) or the Federal Reserve, plays a pivotal role in regulating and controlling money market operations. It acts as a lender of last resort, ensuring liquidity and stability in the market. The central bank also influences short-term interest rates through its monetary policy and open market operations.

• Commercial Banks

Commercial banks are the most prominent dealers in the money market. They borrow and lend short-term funds to manage their liquidity requirements and meet the reserve requirements set by the central bank. They also trade in money market instruments such as treasury bills, certificates of deposit, and interbank loans.

• Non-Banking Financial Institutions (NBFIs)

NBFIs, such as insurance companies, mutual funds, and pension funds, participate actively in the money market. Although they do not have a banking license, they provide short-term financing and liquidity to the market. Their participation enhances market depth and stability by diversifying the sources of funds.

• Primary Dealers (PDs)

Primary dealers are specialized financial institutions appointed by the central bank to participate in the issuance and trading of government securities. Their primary role is to ensure the smooth functioning of the government securities market by underwriting and distributing new issues. PDs also provide liquidity to the secondary market by actively buying and selling government securities.

• Cooperative Banks

Cooperative banks operate at regional and local levels, providing short-term credit to agricultural and rural sectors. They participate in the money market by borrowing funds to meet seasonal credit requirements and lending to small businesses and farmers.

• Discount and Finance Houses

Discount and finance houses act as intermediaries in the money market by discounting short-term financial instruments, such as treasury bills, commercial papers, and bills of exchange. They enhance liquidity in the market by facilitating the conversion of securities into cash.

• Corporations and Large Businesses

Large corporations participate in the money market to manage their short-term financing needs. They often issue commercial papers to raise funds at lower interest rates than bank loans. Corporations also invest surplus cash in money market instruments to earn interest on idle funds.

• Brokers and Dealers

Brokers and dealers facilitate transactions between buyers and sellers in the money market. They act as intermediaries, matching parties for short-term lending and borrowing. Dealers, in particular, may also trade money market instruments on their own account to earn profits.

Arbitrage involves simultaneously buying and selling a security at two different prices in two different markets, with the aim of making a profit without the risk of prices fluctuating.

Arbitrage strategies arise simply because of the way the markets are built. There are inefficiencies in the market owing to lack of information and costs of transaction that ensure that an asset’s fair or true price is not always reflected. Arbitrage makes use of this inefficiency and ensures that a trader gains from a pricing difference.

Depending on the markets involved, there are different arbitrage strategies. There are strategies that relate to the options market and there are specific arbitrage strategies that refer to the futures market. There are also strategies for the forex markets and even retail segments.

Arbitrage in Finance

Arbitrage is the process of simultaneously buying and selling a financial instrument on different markets, in order to make a profit from an imbalance in price.

An arbitrageur would look for differences in price of the same financial instruments in different markets, buy the instrument on the market with the lower price, and simultaneously sell it on the other market which bids a higher price for the traded instrument.

Since arbitrage is a completely risk-free investment strategy, any imbalances in price are usually short-lived as they are quickly discovered by powerful computers and trading algorithms.

Types of Arbitrage

While arbitrage usually refers to trading opportunities in financial markets, there are also other types of arbitrage opportunities covering other tradeable markets. Those include risk arbitrage, retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage.

Risk arbitrage: This type of arbitrage is also called merger arbitrage, as it involves the buying of stocks in the process of a merger & acquisition. Risk arbitrage is a popular strategy among hedge funds, which buy the target’s stocks and short-sell the stocks of the acquirer.

Retail arbitrage: Just like on financial markets, arbitrage can also be performed with usual retail products from your favourite supermarket. Take a look at eBay for example, and you’ll find hundreds of products bought in China and sold online at a higher price on a different market.

Convertible arbitrage: Another popular arbitrage strategy, convertible arbitrage involves buying a convertible security and short-selling its underlying stock.

Negative arbitrage: Negative arbitrage refers to the opportunity lost when the interest rate that a borrower pays on its debt (a bond issuer, for example) is higher than the interest rate at which those funds are invested.

Statistical arbitrage: Also known as stat arb, is an arbitrage technique that involves complex statistical models to find trading opportunities among financial instruments with different market prices. Those models are usually based on mean-reverting strategies and require significant computational power.

Arbitrage trading tips

• If you are interested in exchange to exchange trading, it would involve buying in one exchange and selling in another. You can take it up if you already have stocks in your demat account. You would need to remember that the price difference of a few rupees in the two exchanges is not always an opportunity for arbitrage. You will have to look at the bid price and offer price in the exchanges, and track which one is higher. The price that people are offering shares for is called the offer price, which the bid is the price at which they are willing to buy.
• In the share market, there are transaction costs which may often be high and neutralise any sort of gains made by an arbitrage, so it is important to keep an eye on these costs.
• If you are looking at arbitrage where futures are involved, you would have to look at the price difference of a stock or commodity between the cash or spot market and the futures contract, as already mentioned. In the time of increased volatility in the market, prices in the spot market can widely vary from the future price, and this difference is called basis. The greater the basis, the greater the opportunity for trading.
• Traders tend to keep an eye on cost of carry or CoC, which is the cost they incur for holding a specific position in the market till the expiration of the futures contract. In the commodities market, the CoC is the cost of holding an seet in its physical form. The CoC is negative when the futures are trading at a discount to the price of the asset underlying in the cash market. This happens when there is a reverse cash and carry arbitrage trading strategy at play.
• You can employ buyback arbitrage when a company announces buyback of its shares, and price differences may occur between the trade price and the price of buyback.
• When a company announces any merger, there could be an arbitrage opportunity because of the price difference in the cash and the derivatives markets.

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that may be temporarily mispriced.

In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. The theory was proposed by the economist Stephen Ross in 1976. The linear factor model structure of the APT is used as the basis for many of the commercial risk systems employed by asset managers.

Assumptions in the Arbitrage Pricing Theory

The Arbitrage Pricing Theory operates with a pricing model that factors in many sources of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM), which only takes into account the single factor of the risk level of the overall market, the APT model looks at several macroeconomic factors that, according to the theory, determine the risk and return of the specific asset.

These factors provide risk premiums for investors to consider because the factors carry systematic risk that cannot be eliminated by diversifying.

The APT suggests that investors will diversify their portfolios, but that they will also choose their own individual profile of risk and returns based on the premiums and sensitivity of the macroeconomic risk factors. Risk-taking investors will exploit the differences in expected and real returns on the asset by using arbitrage.

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the market eventually corrects and securities move back to fair value. Using APT, arbitrageurs hope to take advantage of any deviations from fair market value.

However, this is not a risk-free operation in the classic sense of arbitrage, because investors are assuming that the model is correct and making directional trades rather than locking in risk-free profits.

Arbitrage in the APT

The APT suggests that the returns on assets follow a linear pattern. An investor can leverage deviations in returns from the linear pattern using the arbitrage strategy. Arbitrage is the practice of the simultaneous purchase and sale of an asset on different exchanges, taking advantage of slight pricing discrepancies to lock in a risk-free profit for the trade.

However, the APT’s concept of arbitrage is different from the classic meaning of the term. In the APT, arbitrage is not a risk-free operation – but it does offer a high probability of success. What the arbitrage pricing theory offers traders is a model for determining the theoretical fair market value of an asset. Having determined that value, traders then look for slight deviations from the fair market price, and trade accordingly.

Arbitrage Pricing Theory

The Formula for the Arbitrage Pricing Theory Model Is       

E(R)I =E(R)z+(E(I)−E(R)z) ×βn     

where:

E(R)I =Expected return on the asset

Rz=Risk-free rate of return

βn=Sensitivity of the asset price to macroeconomic

factor n

Ei=Risk premium associated with factor i